In Wealth Signals, you'll receive commentary that filters out market "signals" from the "noise" that is the mainstream financial news media. We focus on what matters – which, invariably, is not what you'll hear on CNBC or read in the Wall Street Journal. On the basis of these signals, we'll also issue macro-driven trade ideas to get ahead of the trends and themes that will dictate market direction. (Generally, these will be more conservative income-focused recommendations – and, for more aggressive investors, ideas that aim for capital appreciation.)
Like a cowboy in a frontier saloon, it always pays to have an exit strategy when investing. If not, you might not get out alive.
An old friend of mine – to protect the innocent I’ll call him Teddy – had never once mentioned investing in the 40-plus years we’d known each other. Like many other Americans, saving for retirement was hardly even on Teddy’s radar, as far as I knew.
That is, until the end of 2020. Almost overnight – to my shock – Teddy had become an investing expert.
Rather than the usual chat about the Baltimore Ravens or his kids, Teddy was blowing up my phone with texts and calls about all the money he was making… in the cryptocurrency market. “Cryptos only go up,” he told me. “Hold them and you’ll make millions.”
Needless to say, for me this was an entire United Nations lobby of red flags. Teddy had clearly lost any anchor of his senses: “They only go up” is toward the top of the pantheon of famous last words, along with “I’ll wait to sell at the high” and “This time it’s different.” I knew that Teddy was headed for a financial train wreck, and I wanted to try to slow down the locomotive.
So I asked Teddy about his exit strategy. I wanted to know what his plan was for booking gains when his investments appreciated – and how he’d decide when to cut his losses, when they fell.
But Teddy didn’t have a game plan. In fact, he told me he didn’t need one because his crypto investments were “guaranteed” to keep going up. He said traditional notions of investing were dead, and he said he was selling everything else he owned to put it into crypto.
If you think you know how this story ends… trust your gut.
As the months passed and crypto prices kept rising, Teddy’s gleeful squawking got louder. He sent me photos of umbrella cocktails from the Caribbean, and ski trips to Colorado.
Then, in late 2021, the crypto market changed...
After peaking in November at around $68,000, Bitcoin tumbled 80% to $15,600 just one year later. Over that same span, Ethereum tumbled 77%, from $4,800 to $1,100. And – surprise, surprise – I didn’t hear much from Teddy. Turns out he wasn’t as interested in crowing about his massive losses: Teddy was wiped out.
I’d be telling a very different story (and I might be writing this from the guest suite of Teddy’s yacht) if only he had made use of some simple risk management tools – a trailing stop, for example, which I’ll explain here.
Following the recent rally in the stock market, now is the time to make sure you have a game plan in place to preserve your wealth, no matter what the outcome…
Take the Emotions Out of Investing
Emotions are fundamental to being human. They’re much of what makes us unique. They’re central to who we are. But they’re kryptonite for investing.
As you can see by the story with Teddy, emotions really ramp up when an investor begins to make money. The immediate reaction is to pat yourself on the back and say, “I’m a genius!”
The problem starts when that same investment starts to go down. Suddenly, your brilliance is in question. You tell yourself no one else knows what you do about the asset you’re invested in. And when everyone else “gets it,” things will really take off.
But that pretty much never happens. It’s far more likely that before you know it, you’re looking at an ocean of red, and ice-pick-in-the-skull losses.
To keep that from happening, you need a plan in place that forces you to save yourself from big losses.
This is where trailing stops help. The process is relatively straightforward…
Before you invest in any asset, determine your pain threshold. Are you willing to lose 10%, 20%, or 50% before saying enough is enough? I’ve found that 20% to 25% is my personal pain threshold. Once you’ve established your own limit, it becomes your trailing stop.
It works like this…
It’s called a trailing stop because it’s based on the closing high price from the time of your purchase date. In other words, it will trigger once the asset’s price has dropped 25%, on a closing basis, from the highest level since you’ve owned it. So, when making the investment, you immediately enter your trailing stop level.
This method forces you to book profits as well as losses, because, if the asset never goes above your purchase price, you will exit at a 25% loss. But let’s say it rallies 100% before dropping. Then, on the way back down, when it has dropped 25%, you will sell.
Granted, you won’t make as much money as getting out at the very top (which rarely happens), but you’ll still walk away with a profit.
Limiting Losses Can Be Your Best Trade
When you enter a trailing stop, there are two important points to remember…
First, make sure you don’t put a standing market order in at your level. You don’t want to tell your broker when you’re going to sell. Make this level one you keep in your head. You can also set up a notification that alerts you via email or text.
Second, when the trailing stop is triggered, sell. No questions, no doubts… just do it. Otherwise, inaction can lead to additional losses. Most of the time, when a stock falls, it doesn’t recover. No one wants to see their profit shrink more or their loss increase because they ignored their own trailing stop signal.
Now, let’s use Bitcoin and Teddy as our example. He was invested in a number of different tokens. Here I’m focusing on Bitcoin.
In 2020, Teddy sees Bitcoin explode higher in value, rising almost fourfold from $7,400 per token to just over $29,000. He finally pulls the trigger in early 2021, when Bitcoin’s trading at roughly $40,000. At that point, if he put a 25% trailing stop in place, he’d sell when the price dropped back to $30,000.
However, Bitcoin kept running up over the next four months to a peak of almost $63,200 before it experienced its first big pullback in 2021. At that point, Teddy’s trailing stop would have moved up to $47,400 (that’s 25% beneath the peak), and he could have exited with a roughly 19% gain from his purchase price. Unfortunately, he didn’t.
Bitcoin fell to just under $30,000 in early July. Then as it started to rally back toward $40,000 by the end of the same month, he doubled down and bought more Bitcoin. By late October 2021, when the price was $65,000 and crypto was making millionaires, he was all in.
A trailing stop would have prompted Teddy to sell once Bitcoin fell back to the $49,000 level, by the end of 2021. But he was too emotionally wrapped up. He was convinced he had to hang on just a little longer before a rally to even higher levels.
That didn’t happen. Teddy didn’t throw in the towel until late 2022, after losing close to 80% of his capital. He was devastated by the loss and swore he’d given up on investing forever.
Remember, everyone gets emotional and makes mistakes. It’s part of the process. But learn from them.
Instead of throwing money at an investment, hoping you’ll be successful, have a plan in place that covers every outcome. Use trailing stops to minimize any downside while also forcing you to book gains. It will allow you to sleep at night no matter the investing environment, because you’ll know you’re covered.
Last week, we recommended buying shares of Amazon (AMZN) with a 25% trailing stop. If you had purchased them at $125, your 25% trailing stop would be at $93.75.
However, if the price rises to, say, $200 over the next 12 months, the trailing stop will move up to $150 (and of course it would move up as the share price appreciated). So, even on a 25% pullback from that level, you’d still walk away with a 17% gain.
Don’t be like Teddy! Get your emotions in check before you even get started. That way, you’ll hang onto more of your hard-earned money – and have plenty to invest in growing your wealth through future opportunities.
Porter & Co.